WSJ M&A 101: Reverse Termination Fees and ‘Social Issues’

Ronald Barusch spent more than 30 years as an M&A practitioner at Skadden, Arps, Slate, Meagher & Flom LLP before retiring this year. He is no longer affiliated with the firm and the views expressed here are his own.

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By Ronald Barusch

It’s time for the third lesson in our series about the hidden world of deal making. In two prior posts, I described the provisions in merger agreements giving each side the right to drop out of a deal, and how a corporate buyer protects itself from rival bidders.

Now for the other side: What happens if a buyer can’t complete a transaction even though nothing has gone wrong at the company to be acquired? And how will management of the target company be treated following the deal?

Reverse Termination Fees. The name says it all: This is the opposite of the typical “breakup fee,” which is paid by a target company to the initial buyer if the target takes another offer.

In a reverse termination fee, it is the prospective buyers who fork over money when an acquisition doesn’t close, if it’s not the target company’s fault. This is a topic that did not come up in merger agreement negotiations until a few years ago, when private equity players started to become prominent buyers.

When a company like Pfizer agrees to buy King Pharmaceuticals for $3.6 billion in cash, there is no need for a reverse termination fee. Even if plans to borrow some money for the deal, Pfizer can easily afford the purchase price, there is no financing condition and the conditions to Pfizer’s obligations to close can be specified in the merger agreement along the lines of my prior post. If Pfizer refuses to close the deal and the companies’ contract requires it to do so, King Pharmaceutical can run to the courts to force Pfizer to finish what it started.

In short, Pfizer’s entire balance sheet is behind the deal and there is no question that King Pharmaceutical could obtain a remedy if it needed one.

But when a private equity firm buys a public company, like KKR’s recent deal for Del Monte Foods or TPG and Leonard Green’s agreement to acquire J. Crew , it is a bit more complicated. That is because in every private equity acquisition, there is a “deal behind the deal”. The actual buyer is almost always a “shell”—or a company formed just for the purpose of the transaction. (In the J. Crew deal, for example, the shell company is called “Chinos Acquisition Corp.”)

There is nothing dishonest or unusual about this: the PE sponsor will commit its equity to the deal, but that will not be enough to pay the entire purchase price; much of the money must be borrowed. For confidentiality reasons, and to avoid spending a ton of money on transaction costs for deals that go nowhere, most of the “deal behind the deal” is done after the public announcement of an acquisition.

PE firms don’t generally put their entire balance sheets behind a single acquisition. Frequently their agreements with PE investors don’t permit them to take that risk.

Surprises do happen. And even if there is is no formal financing condition, it is not so easy for the target to run to court to force a deal to close. If the bank financing is not completed and the purchaser is a shell, the PE sponsor might be perfectly willing to put up the equity, but this will not be enough to complete the transaction.

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Initially, because of their similarity in structure to breakup fees, the reverse fees were frequently the same amount. But if a PE buyer is left at the altar, it generally pockets the breakup fee and moves on to the next deal with a profit. Targets fare much worse if a corporate marriage falls through. Employees expecting a takeover have moved on or are looking for new jobs. And when a deal is announced, a target company’s shareholder base tilts literally overnight towards arbitrageurs, who tend to put tremendous pressure on a jilted target to accept a new deal.

After there were some prominent deals which left targets with relatively minimal reverse termination fees and massive litigation —Huntsman being an infamous example–buyers and targets began to argue about “specific performance” clauses, or an agreement provision which contains a request to a judge to force the parties to carry out their promises as written, rather than relying on cash compensation for breaches. In some cases, targets sought the right to force banks to fund the commitment letters addressed to the PE sponsors. This idea is not popular with banks, needless to say.

What seems to have become standard now is a reverse termination fee that substantially larger than the breakup fee. In the KKR/Del Monte deal, for example, the reverse termination fee is two to four times the breakup fee—or 7% of the total purchase price. In TPG/J. Crew the reverse termination fee is four to seven times the breakup fee—or again about 7% of the purchase price.

Seven percent of the purchase price may still not make a jilted target whole, but it certainly is a tidy sum of cash to nurse its wounds.

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Social Issues. It’s not only deal price that buyers and sellers tussle over. They also negotiate over who will be in charge at the new company, and other “social issues” such as the location of corporate headquarters, treatment of employee stock options, the makeup of the board of directors, maintenance of employee benefit plans after the closing and post-closing indemnities and insurance for target officers and directors.

Indeed, if you were cynical, you might think that sometimes the difference between a “merger of equals”—where neither side’s shareholders receives a premium—and an acquisition in which target shareholders receive a substantial premium, may turn on which individuals will be running the combined companies. Merger of equal negotiations are more complex than this, but it certainly is a factor.

These social issues are sometimes spelled out in the agreement and in other cases there are more informal arrangements—which should be, and usually are, disclosed in the proxy statement.

There can be, of course, an inherent conflict on some of these issues. Frequently, independent board committees are formed specifically to resolve social issues. Social issues generally don’t involve large financial commitments relative to the size of the transaction. But if you put yourself in the place of the executive officers of a target company—even if they have generous golden parachutes—you can see why the social issues are critical in many deals.

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With this you are now equipped to negotiate your own merger agreements–or if not quite that, at least understand the more important issues discussed when you a read articles about them.

Comments (3 of 3)

Hey very nice blog!I’m an instant fan, I have bookmarked you and I’ll be checking back on a regular.See u.

12:44 pm December 2, 2010

Matt Porzio wrote :

Ron – I’ve enjoyed this series of blogs. Extremely insightful. Part one really caught my attention. It actually prompted me to write my own blog. I completely agree that “each side wants to feel it received a ‘fair’ number of points against its negotiating partner [and] this, of course, encourages each side’s lawyers to raise lots of points”. One point, which is closely related, is the due diligence that precedes these agreements. Diligence continues to change and improve – dealmakers now focus on accelerating the deal process and negotiations. It’s key to have a seller (often coached by advisors) providing greater levels of information throughout the process, creating comfort with the buy-side who in turn becomes more reasonable in negotiating and committed to the deal itself. This information sharing is facilitated by technology such as online datarooms / virtual dealrooms, which helps to ensure the process is organized, collaborative, comprehensive and interactive. It can smooth a rocky road to closing, allowing everyone to focus on materiality and avoid it where “lawyers fight over these words”. As a former banker it still pains me to think about deals that got bogged down - the wasted time, added effort and risks when it got competitive among the lawyers. The legal work is necessary to protect all parties involved, but too much can indeed make good deals, go bad.

8:04 pm December 1, 2010

Santa Liquidation Clause wrote :

I love these M&A related articles by Mr. Barusch. Even as an experienced merger arbitrageur, I find things I didn't know or fully grasp explained very clearly. Kudos to you and to the WSJ for having the foresight to publish your words. Keep up the good work. Worth the price of my online subscription for these alone.

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